How much should a small business owner earn?
Photo by Bruce Mars on Unsplash
One of the challenges small business owners and independent professionals face is the challenge of remuneration. People easily get confused about what amounts to a reasonable wage they should receive from their business. At the same time, some overpay themselves, which could affect the business in the long run. Many underpay themselves, and this could be an unmotivating influence that could wane their commitment and also affect the long-term growth of the business.
However, the decision to pay yourself and how much you pay is critical and must be rightly decided. To make these decisions, it’s necessary to consider important factors like taxes, the nature of your business, etc. This article examines all you require to make the right decision to pay yourself.
Should you receive a salary as a small business owner?
Paying yourself is essential to your long-term success and viability. If your business is struggling and you're frequently short on cash to cover personal expenditures, you might wonder if it's worthwhile to keep it going. Pay yourself for the priceless asset that is your time.
Additionally, your books won't correctly reflect the state of your company's operations if you don't account for your salary. Because you are not accounting for your compensation, you will not be aware of the company's true earnings.
Factors that determine the average compensation for small business owners
As we have already stated, paying yourself a salary is very important as it impacts your business. However, there's no hard and fast rule for determining the average salary of a small business owner. It boils down to some factors: The nature of the business entity, average Compensation, profit, tax considerations, location, etc. We'll examine these factors in detail.
The nature of your business entity – whether it is Incorporated or not
You are considered an employee and eligible for salary if your company is Incorporated. The corporation reserves the right to deduct your salary, and you are required to pay taxes on it as ordinary income.
Payroll taxes generally add 1.25 to 1.4 times the compensation to the cost of doing business. For instance, a wage of $100,000 would cost the company between $125,000 and $140,000. The sum varies depending on the amenities offered, including health insurance, retirement plan contributions, personal use of corporate vehicles, and other perks.
On the other hand, you're not an employee and therefore not entitled to salary if your company is not Incorporated – that is, if it's a sole proprietorship, partnership, and limited liability company (LLC). A "draw," or company funds distribution, is an alternative. You are taxed on your part of the business profits whether or not they are transferred to you, and neither the business nor you can deduct the draw from their expenses.
For instance, regardless of the amount that is distributed, a partner is considered to have received a distributive share of firm profits for tax reasons and must pay self-employment tax on this sum. Distributions to LLC members and partners are typically governed by the terms of an LLC operating or partnership agreement.
Payscale puts the average income of a small business owner at about $68,000. A greater percentage of small business owners earn less than $100,000 annually, and many earn nothing at all.
There is no doubt that the word "average" is fairly broad. Concerning the kind of business, compensation differs greatly. The salaries of professionals and craftspeople, such as accountants, architects, and plumbers, are frequently higher than those of proprietors of boutiques and salons. Moreover, the average is influenced by other factors.
Also, remember that many small business owners accept remuneration far greater than the average to achieve the term "average."
Your income may change depending on whether you receive a salary or an owner's draw from your company.
Essentially, if you do not receive a salary, your income is based on your profits. Your pay may be lower than it would be during a time of high business profitability. There is a probability that, as a start-up, your business won't even make a profit until at least the second year. In this case, you can choose to take home just enough money to cover your bills.
The SBA reports that a higher percentage of small business owners peg their compensation at 50% of their revenue. In other words, if your company makes $300,000, your income shouldn't be more than $150,000. Some business owners' paycheck increases along with their company's profits.
Where you locate your business determines to a large extent, the business's earnings and, by extension, yours. While some localities have a higher cost of living than others, other places demand certain goods and services more than others. All these affect the income of a business owner.
The State Occupational Employment and Wage Estimates guide from the BLS organizes wage data by state, industry, and occupation. This tool can be used to compare salaries for various jobs. You might earn more in some regions than others because city size and costs are correlated.
Many tax factors are taken into account while determining remuneration:
A business can deduct only pay that is considered "reasonable." The IRS regularly examines this deduction category for C corporations to ensure payments to owners are acceptable in light of different variables (such as the work completed and the company's profitability). Dividends, which are not deductible by the corporation but are nonetheless taxed to owners, can be considered excess compensation (amounts that are not justified). Over time, S firms have tended to decrease payments to reduce employment taxes (remember, owners, are taxed on their share of profits, so a deduction for salary to them is not as meaningful as in the case of a C corporation). S corporations' attempts to avoid paying owners any compensation even if they provided services to the company have been effectively defeated by the IRS. Setting remuneration at least at the Social Security wage level ($142,800 in 2021) has been a frequent approach for businesses aiming to avoid employment taxes. Again, whether or not this is logical is debatable.
The QBI deduction
For business owners with taxable income that exceeds certain thresholds, salaries (W-2 earnings) play a significant role in calculating the qualified business income (QBI) deduction (adjusted annually).
The annual payments made by shareholders of companies with qualifying retirement plans are determined by their compensation.
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Here's how Workee can effectively manage your services as a freelancer
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Workee helps you manage your finances, such as tax, invoice, and accounting. It comes with customized invoice templates for your services and appointments. You can also issue automated invoices and track your payments.
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It is not in doubt that paying yourself a salary as a small business is crucial as it directly impacts your business in the long run. However, this should be done by observing our examined factors.
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